Friday, October 30, 2009

Pinnacle’s Proprietary Investment Process

Of late, for one reason or another, I’ve spent a lot of time describing Pinnacle’s investment process. For the record, the best explanation of our process is that we have a multi-faceted approach to decision making that considers fundamental or traditional valuation analysis, analysis of business and market cycles, as well as technical analysis of investor behavior. This is but another example of why we believe in diversification, although in this case it results not only in portfolios with diversified asset holdings, but a portfolio where decisions are based on more than one kind of analysis.

I’ve written previously in this space that I believe that investors who are interested in active management will first explore the technical method of tactically allocating portfolios. Using technical analysis has many benefits, perhaps the most important of which allows the advisor to develop several “rules” for following favored indicators. These rules then become a quantitative approach to decision making that is relatively simple and relatively effective. Most of the active managers that I’ve reviewed are using some type of quantitative system based on simple trend following or momentum rules – all of which are based on technical investing techniques such as relative strength, oscillators, trend lines, etc. The resulting system becomes a “proprietary decision making process,” a very valuable product to sell to investors. For the record, a proprietary process implies a secretive, valuable, exact, scientific, repeatable process that no one else can duplicate.

At Pinnacle we have also developed a proprietary investment process. It’s called “doing the work.” Unfortunately our process requires us to make qualitative as well as quantitative decisions about asset allocation. And to my knowledge, there is no easy way to make a decision based on the weight of the evidence as determined by our judgment, experience, and expertise. For us it means slogging through the 100-plus economic releases each month to find clues regarding the market cycle, Fed policy, currency direction, etc. It also means reading daily, weekly, and monthly research reports from dozens of brilliant analysts who disagree with each other all of the time. Marrying this process with our own proprietary quantitative approach is nothing but hard work. But it sounds a lot better when we call it our proprietary investment process. For the record, our proprietary process is inexact and messy, but I have a great deal of confidence that it is the lowest risk method for making investment decisions.

Thursday, October 29, 2009

Portfolio Construction – Embracing Different Expressions of the Same View

I have the unusual mandate of being the lead portfolio manager for both our most aggressive (Dynamic Ultra Appreciation) as well as our most conservative (Dynamic Conservative) model portfolios. Some might think that managing the tail ends of the risk spectrum is a recipe for a mental breakdown, as one has to have an almost schizophrenic mindset that changes from an emphasis on maximizing investment returns to minimizing potential losses, depending on which model is being analyzed. Actually, it doesn’t bother me a bit, because our process is tailor made to deal with such a job. Our investment team is constantly evaluating our three primary building blocks (macro fundamentals, market technicals, and valuation) in order to develop a forecast. While our forecast certainly directly influences overall portfolio allocation, it doesn’t mean that we have to buy and sell the same securities or execute trades at the same time in policies that have very different objectives. In fact, our process and philosophy encourage us to treat each model independently when applying our forecast.

As an example, right now we are cyclically bullish due to improving fundamental data and the positive technical condition underlying the financial markets. As a result, we’ve tilted most portfolios towards reflationary assets, which we believe have the most appreciation potential in the current environment. We have the highest percentage of these explosive assets in our most aggressive portfolios, because we think they will make the most money if we are correct that the bull market has more cyclical running room. However, we also clearly recognize that these assets (like emerging markets, late cyclical equity sectors and commodities) are typically very volatile, and simply don’t synch up with our mandate to protect principal for our most conservative clients. Therefore, our Dynamic Conservative model has almost no reflationary assets in the portfolio. Instead, for those clients, our pro-cyclical view is reflected mostly in the fixed income arena in the form of a material percentage of lower quality credit. This is just one example of how we can have one unified view but two very different policy objectives, which require very different portfolio allocations.

At Pinnacle, we manage all of our portfolios using the same philosophy, process and investment views, but we never lose sight that our clients are different people with different goals and risk tolerance. Therefore we embrace having both a unified view of the world, and many ways to express that view through our portfolio construction.

Wednesday, October 28, 2009

Consumers Facing Rising Gas Prices – Again

Bad news for the already fragile U.S. consumer – gas prices are on the march again. They mostly drifted sideways throughout the summer during the initial stages of the economic recovery, but they’ve climbed to $2.68/gallon over the past few weeks (using the AAA Daily National Average Gasoline Price from Bloomberg). Last year’s rollercoaster ride is probably still fresh in most drivers’ minds, when crude oil soared to $145/barrel and pump prices rose to over $4/gallon during the summer, only to collapse to $1.62/gallon by December as economic activity ground to a halt.

It’ll be worrisome if the recent rise continues, since consumers are already struggling under the weight of several well-documented issues, including rising unemployment, falling home prices, restricted access to credit, and falling wages. Now, they again face the prospect of higher gas prices, as businesses bring more and more idle resources back online, causing demand for commodity inputs to increase. U.S. consumers have certainly proven to be a resilient bunch for a long time, but they are being challenged mightily at present. It will not be a welcome development to see gas prices surge appreciably higher, since they effectively act like a tax by siphoning off additional dollars that consumers are already being more discerning about as they tighten their belts in the current environment. A surge in energy and other commodity prices similar to last year’s is on our list of risks to watch for that could short-circuit the economic recovery.

Friday, October 23, 2009

Smart Money

There are a few indexes that are very useful in confirming an existing trend. As the market continues to rally, it is perceived to be a good sign when these confirmation indexes are also rallying to new highs. One such index is the Smart Money Flow Index, which is an offshoot of other last hour indicators published by Wall Street Courier. The index measures the market movement in the first 30 minutes and the last hour of trading. The first thirty minutes of trading is generally considered emotional trading, driven by greed or fear based on the overnight news. Therefore it is used a contrarian signal, which means that the index will subtract market gains or add market selloffs during this period. The last hour of trading is dominated by large institutions, or smart money, as they take the day to evaluate price action and execute orders in a big way. These big traders have the best research or information available to them, and therefore you would want to trade with them. The index will add market gains or subtract market selloffs during this period.

Below is a chart of the Smart Index from 11/1/08 to 10/22/09. As you can see from the chart the smart money is rallying with the overall market and confirming the strength in the market. This index has also been very useful in calling market bottoms and market tops. Going into the March lows, the index did not reach new lows when the Dow kept falling which signaled that most sales were due to ‘dumb’ money. That was an important sign as the heavy hitters were less fearful than other traders. We will keep monitoring this index for signs of divergences. If the market continues to rally and this index flatlines then it might be a signal that a near term top could be forming.

Thursday, October 22, 2009

Earnings Watch – Start Paying Closer Attention to the Top Line

It’s hard to believe, but another earnings season is underway, and at this point about 30% of S&P 500 Index companies have already reported quarterly results. So far, the quarter is mirroring the prior several quarters in that actual earnings are down for 7 out of 10 sectors, but 9 out of 10 sectors have reported positive earnings surprises (earnings that were ahead of consensus analyst estimates). What may be different this quarter is what investors are expecting in order to keep the rally moving. For two straight quarters positive earnings surprises were enough to move an oversold and nervous market higher. But going forward, additional gains are going to require an improvement in “top line” growth for companies, meaning a pickup in core business sales and not just better earnings based on cost-cutting.

Looking at the sales numbers so far gives a far less rosy picture than earnings, particularly when it comes to expectations (see data from Bloomberg shown below). The good news is that the Conference Board’s Leading Economic Index was up again today, and continues to imply improving economic growth and a pickup in sales at some point in this recovery. However, this common sense logic only works if the leading indicators function as well as they used to, given the current credit-constrained and deflationary environment (last I checked the velocity of money is not included in any of the leading indicators).

Let’s hope the leading indicators are still reliable, because after the rally we’ve experienced off the bottom, the market is no longer undervalued or oversold. In fact, it’s fair to say that on a short-term basis the market is very overbought. Momentum investors can certainly prop up markets temporarily, but they can also turn on a dime given the right catalyst. The bottom line is that we better see a pickup in sales sometime soon, otherwise a lack of organic growth may become the negative catalyst that causes a long overdue correction in the financial markets.

Tuesday, October 20, 2009

Found: A High Conviction Forecast

Task number two this weekend was to catch up on my investment research, a seemingly endless proposition that punishes my weekly tendency to procrastinate in my reading. Task number one was to write a marketing brochure for Pinnacle to use in a potential new venture. I have written our story so many times that it’s difficult to get overly enthusiastic about doing it again, but I am the Chief Investment Officer and explaining what we do is a big part of the job. An important part of our story is our belief that relative value investing makes sense. For us, relative value essentially means that we will vary our portfolio construction based on our conviction in our investment forecast. We measure our success in earning excess returns for our clients by comparing our results to a portfolio with a fixed asset allocation. The special name for this hypothetical portfolio is our benchmark, and if we are successful in identifying good investment values we will earn excess returns relative to our benchmark.

While pondering (once again) how to explain the intersection of benchmarks, value investing, tactical asset allocation, and high conviction forecasts, I decided to take a break and read a research piece from Lombard Street Research called, Deflation to hit Germany and America. Charles Dumas is the well respected analyst who penned this somewhat technical and very detailed piece on his views regarding the outlook for deflation in the U.S. and Germany. While I shouldn’t have been rewarded for deviating from task number one to dally in task number two, I couldn’t help but be struck by the certainty in Dumas’s forecast. In fact, the Pinnacle investment team reads hours and hours of research, and I can safely say that Dumas went way out on the limb of high conviction writing. Here are a few examples:

“For the time being, with stock and house prices down some 30-40% from their peaks, people worrying about booming asset prices causing inflation have to be seriously detached from reality.” Or, “In these conditions, financial collapse centered on the dollar is verging on the impossible.” And my personal favorite, “To talk of inflation resulting from this is plain stupid.” I say bravo to Mr. Dumas. We highly value analysts who advance clear points of view and back them with sound analysis. This is not to say that I personally agree with Lombard’s deflationary case for the world, which is by the way, rather gloomy reading. However, it is a good reminder of how our investment process works. When we occasionally have the same level of conviction as Mr. Dumas, Pinnacle clients can expect larger rather smaller deviations from our benchmark portfolio. And if our forecast is correct, it is from these conditions that we would typically generate the most excess returns for our clients.

Friday, October 16, 2009

International Demand for U.S. Debt Remains Steady

Each month, the U.S. Treasury Department issues their Treasury International Capital report, which contains detailed information on international demand for U.S. securities. Normally, the report is not a headline grabber, and may only get a passing reference (if that) by most media outlets. But lately, some investors are paying more attention to this report, since the value of the U.S. dollar has come under increasing scrutiny. Since March 9th, which was the same day that equities bottomed, the dollar has fallen by -15% (on a trade-weighted basis), while the S&P 500 Index has rallied +62%. Since some countries (particularly China and Japan) have purchased very large quantities of U.S. Treasury debt, they aren’t exactly thrilled that their dollar holdings are falling in value, and have been very vocal lately about their desire to create some sort of new, global currency as an alternative to the greenback.

But for all the rhetoric, it seems that demand for U.S. debt has remained fairly steady. On a 12-month rolling average basis, foreign entities purchased $337 billion of U.S. Treasury notes and bonds in the year through August. As shown on the chart below, net purchases have held in a range of roughly $200 - $400 billion for the past several years, and foreigners haven’t been net sellers since earlier this decade. Part of the issue is that despite public statements, some countries have such large reserves that they don’t have realistic alternatives to Treasuries right now.

We’ll continue to monitor this data to see if these countries begin to back up their words with actions going forward, which could have very negative implications for the buck. But for now, it seems to be just a lot of posturing.

Thursday, October 15, 2009

Are Contrarian Signals Flashing?

Behavioral studies in finance are a fascinating subject that attempt to prove how irrational we as humans can be, and how those traits carry over to the world of investing. At Pinnacle we try to use this valuable information to be contrarian investors at times. A contrarian by definition is a person who invests contrary, or opposite, to popular opinion when crowd behavior moves market prices to extremes, either too high or too low. As investors stampede into or out of different “hot” investments, the market often catches the masses off guard by making sudden, violent moves in the opposite direction (Tech stocks in 2000 are the most glaring example). This week, we have picked up on a few signals that have raised our contrary antenna.

Barron’s Magazine is a respectable journal in the finance community, but nevertheless they are still a part of the media and are subject to over exuberance at times. On October 12th, the magazine ran a story about the salvation of Bill Miller, the famous mutual fund manager who struggled mightily the past few years, titled “It’s Miller Time.” The article explains that the Legg Mason Value Trust Fund managed by Mr. Miller is “up a whopping 37.52% so far this year, putting it in the fifth percentile of all large blended-fund returns.” First, congratulations to him on the big rebound, but come on, “It’s Miller Time?” His fund cratered by -72% from the top of the market in October 2007 to the bottom in March, which was much worse than the S&P 500’s frightening -55% plunge. That means his fund is still down 45% from the market top! If that’s “Miller Time,” then I’ll be reaching for the Silver Bullet.

We switched TV stations in our office from CNBC (disparagingly referred to as “Bubblevision” by some critics) to Bloomberg, coincidently right at the March lows. However, yesterday even Bloomberg surprisingly paraded the Dow 10,000 hats normally reserved for Bubblevision. We hear the argument that 10,000 is a very important psychological level, but more and more people seem to be partying like it’s 1999. CNN has an article this morning titled “Stocks look beyond Dow 10,000.” With bullish excitement building, it would not be surprising to see a short-term market peak sometime soon. And then it will be time to see if the fundamentals justify this run, or if it is time to become a contrarian and head for the exits in the face of the rapidly growing enthusiasm.

Wednesday, October 14, 2009

Retail Sales, Spending & the Magnitude of the Rally

Yesterday, a weekly retail same-store sales report was better than expected, with a +0.6% monthly gain versus expectations of a -2.2% decline. The chart below shows the Johnson Redbook Same Store Sales Index on a year over year basis, and as you can see it recently climbed into positive territory. This index is a sales weighted index of same store sales, or sales in stores continuously open for 12 months or longer. It is broad based, and according to Bloomberg, it represents over 80% of the official retail sales data collected and published by the Department of Commerce. Just this morning the Census Bureau published the advance retail sales numbers for the month of September, and they were better than expected, but still fell by -1.5% for the month, and -5.7% over the past year. Much of the pullback from the prior month’s gain came in the form of Cash for Clunkers payback, as auto sales was the biggest contributor to the monthly decline.

We’ll continue to watch retail sales and consumer spending closely, as spending may hold the key to the duration and ultimate magnitude of the current bull market rally. If the stimulus that fueled the current cyclical rally can create a sustained upturn in spending, than there is a chance that a material healing in top line revenue growth could be in the offing. Stronger revenue growth could feed into better profits, firmer employment, healthier income and net worth, higher assets prices, and ultimately the creation of a self-reinforcing feedback loop that keeps this bull market humming for longer than most anticipate. This would be the best case scenario and we would love to see it unfold. But as investors, we need to constantly look forward with objective analysis and healthy skepticism. We are encouraged by recent numbers, but are also fighting against growing complacent regarding the recent improvements, particularly since some of the stimulus that has supported recent spending has already been withdrawn (Cash for Clunkers) or is scheduled to wind down over the next quarter (first-time homebuyer’s tax credit and the Federal Reserve’s Treasury purchases). Enjoy this rally, but don’t get too comfortable.

Friday, October 9, 2009

Are Bonds and Stocks Telling Us We Are in a Sweet Spot?

The dollar continues to fall, reflation trades rage on for the moment, and risk assets are currently in vogue. But has anyone noticed that Treasury bonds have been rallying, too? How could it be that government bonds, which usually thrive off poor economic news and financial misery, could rally at the same time as the high-flying equity markets that benefit from economic and profit growth? Some of the technical (non-fundamental) reasons for the rally we’ve seen recently include ultra-low returns on cash causing nervous investors to seek something safe with a better yield, central banks that continue to park large reserve balances in bonds because of a lack of better alternatives, and banks that would rather buy Treasuries because they’re still reluctant to lend. Some will look at the divergence between bonds yields and stocks and conclude that one market has to be wrong - either bonds are correct and the economy is softening, which is good for bonds and bad for stocks, or stocks are correct and the economy is improving, which is good for earnings and stocks but bad for bonds.

I have a different view, which is that lower yields may be just be signaling that inflation is currently not a problem. One only has to look at the very low levels of capacity utilization, the large negative output gap (the difference between potential GDP and actual GDP), and slack in the labor markets to realize that the economy has plenty of room to grow before inflation pressures build. That has created a sweet spot for equities, allowing them to rally in unison with a cyclical rebound in economic activity without having to worry that the Federal Reserve will be pressured into prematurely tightening monetary policy. We won’t always be in this sweet spot, and at some point much higher or lower yields will probably portend either a tightening environment or very poor future economic growth, neither of which would be good news for the equity markets. But for the limited window that this goldilocks sweet spot exists, I suppose we should all try to enjoy it!

Wednesday, October 7, 2009

Consumer Credit Still Declining

Today, the Federal Reserve announced that total U.S. consumer credit fell by $12 billion in the month of August (a drop of $10 billion was expected). The index, which covers most short term and intermediate term credit including credit card debt, has now declined for the seventh consecutive month as consumers are borrowing less money, saving more, and paying down their existing debt (see chart below). It is not surprising to see this behavioral change as unemployment continues to grind higher, and hopes for a consumer led recovery are slowly crushed.

As the consumer is currently 70% of the economy in the U.S. this is definitely a near term headwind as we recover from the worst recession in 70 years. And most experts expect this decline to continue as unemployment will remain at elevated levels, banks continue to reduce credit lines available to the consumer, and new credit card reforms hinder their growth. However, this is a very important trend leading to long term, positive fundamentals in our economy. Americans are starting to get their budgets in order and ridding themselves of excessive debt but watch out world – you will have to pick up the slack in demand!

Monday, October 5, 2009

Thoughts on Investment Time Horizons

Sometimes I pine for the good old days at Pinnacle when the prime ingredient for measuring investor success was patience. Back in the day when we were strategic buy and hold investors, the returns of the asset classes that we owned in our portfolio were assumed to be a given, as long as we waited long enough for them to appear. Since the underlying theory suggested that markets were always efficiently priced, and since our clients agreed that returns could and should only be measured over the “long-term,” we could asset allocate our portfolios based on past returns. With the backing of the financial media and virtually all of our industry pundits and thought leaders, everyone involved agreed that patience was the key to success.

Times have certainly changed for the Pinnacle investment team (Truth be told, in the old days we didn’t have a Pinnacle investment team because there wasn’t a need for one!). Today we actively manage portfolios to take advantage of changes in asset class valuations, changes in the market cycle, and changes in market internals such as investor sentiment. The challenge of this strategy is that in today’s markets the data comes fast and furious and the financial markets can be influenced by the news in unforeseen and unpredictable ways. The inevitable result of such fluid market conditions is that the holding period for securities in the portfolio continues to shrink. Where we used to hope to hold equity positions for periods of years, we now would be happily surprised if that were the case. The market rally since March 9th is a good case in point. As the markets have violently rotated from defensives to early cyclicals to late cyclicals, investors who were not nimble enough to follow the cycle missed out on excellent opportunities for excess returns.

Last week, our portfolio manager for our Dynamic Ultra Appreciation portfolios, Rick Vollaro, put on a trade to possibly take advantage of what we perceive to be the short-term overbought condition of the market. He sold a position in an exchange trade fund that owns the Materials sector and bought a 2x inverse position in the same sector, effectively reducing our equity exposure in that portfolio by 10%. He intends to take the trade off as soon as we get the correction that he is anticipating. The good news for me is that Pinnacle has the expertise and the technology in order to execute such an innovative transaction with ease. However, I can’t help but smile at the gigantic changes that have occurred in our portfolio management philosophy over the past 7 years. We wouldn’t have considered this trade, even in our most aggressive portfolios, as little as two years ago. Today we consider these kinds of transactions to be a reasonable and necessary part of our risk management process and an integral ingredient in our quest for excess returns in difficult markets. We’ve come a very long way from patience being the primary strategy we rely on to earn expected returns for our clients.

Thursday, October 1, 2009

Our Own Overbought Analysis

The SPDR S&P Metals & Mining ETF (ticker: XME) created a near term peak at just over $50/share on September 17th, 2009. It’s risen from $20.55 on March 2, 2009 for an incredible gain of 143% over a six month period. We initially bought this fund for three of our models on April 27th and have enjoyed the ride higher as it has been our best performing holding since then. Recently, this position has also provided us with a very important look into overbought market conditions.

At Pinnacle, we utilize a rebalancing software tool called iRebal to streamline our trading process. To avoid boring every reader I’ll stick with the point at hand and not dive into the overly complicated world in which I live using this tool. iRebal uses band thresholds, which is a fancy term for how it determines when to rebalance a security after periods of either under or out performance. For example, if our model position size is 3%, iRebal will signal that a rebalancing trade is necessary if market movements cause the position to change by 1% or more from its intended target, in either direction. In this case, thanks to outsized gains since our purchase, XME was rebalanced (sold) back down to its target for a majority of our client portfolios – right at the short term peak on September 17th!

It is hard to be this exact when monitoring overbought conditions but this does give us one more tool in evaluating market conditions. Materials, and especially Metals & Mining stocks, have been a leader since the market bottom in March. As Rick Vollaro recently wrote, we could see a short term correction here as the market catches its breath. The recent rebalancing trades in Metals & Mining might be an important clue that a broader correction is developing, because when market leaders pause or begin to correct after a strong move like the one we’ve seen, the rest of the market often follows.